By Benjamin Appen and James Hall
In February 2007, Magnitude described how market failure can impact hedge fund investors, and how Magnitude thinks about shock risk management through a full market cycle. This essay was recently adapted from that communication.
There’s a paradox at the heart of Magnitude’s shock risk management protocol. We say frequently that we’re more focused on managing “shock risk” exposure (risk of loss during periods when markets function badly) than “normal risk” exposure (risk of loss during periods when the markets function more normally). We point to leverage, complexity, and illiquidity as major contributors to shock risk.
At the same time, we believe hedge fund investors should focus disproportionately on market-neutral strategies, which are by their nature more likely to be leveraged and often make use of complex securities and illiquid derivatives to construct intricately hedged portfolios. How can this make sense?
In short, it makes sense because we believe the market pays investors for carefully managing shock risk exposures. We think excess returns (over a full market cycle, including a shock period, and excluding beta returns that can more sensibly be earned in lower fee vehicles) earned by portfolios with such exposures are much more attractive than by hypothetical portfolios that have been immunized against shock exposures.
Broadly speaking, investors either can bet on the returns of broad markets (by investing in passive index-type products) or can try to extract value from inefficiencies in these markets. The reason hedge funds exist is to take advantage of inefficiencies. The fees are just too high for investing in hedge funds to make sense otherwise.
Inefficiencies occur disproportionately in markets that work less well. The most efficient sectors of markets are the spaces accessible to everyone, where millions of professional and amateur eyes track every new development, and vote with their dollars on its impact. The least efficient sectors are those where it’s hard to invest: illiquid markets, markets where special expertise is needed to evaluate opportunities, markets where information is scarce. As long as investors remain risk-averse, assets that are hard to trade, complex, and opaque will tend to be cheaper than liquid, simple, transparent assets. When risk aversion goes up (generally when markets go down, and always when markets are shocked), these hard-to-price assets usually get cheaper faster. Many of the best opportunities are found when inefficient markets leave assets so much cheaper that they compensate investors more than fairly for the additional risk. As a result, even the best investors in the inefficiency business expect to lose money during periods when markets are shocked.
This essay will explore Magnitude’s views on shock risk management in more detail. We’ll touch briefly on normal risk management, but our goal is to try to clarify the more complex questions of what shocks are and how we believe investors should try to manage their exposure to them.
Bimodal Risk Management
For an investor, risk management is the attempt to understand and control the distribution of possible return paths for a portfolio. The standard approach to risk management for modern investment institutions is primarily data-driven. Investors use historical information to try to evaluate prospective exposures, working under the assumption that the future will be more or less like the past. Most of the time, this assumption works just fine. Fundamentally similar instruments tend to behave in similar ways; riskiness metrics (volatility, correlation, and their various complicated children, such as skew and kurtosis) generally persist over time.
Infrequently, though, this assumption is turned on its head by periods of anomalous market action. Magnitude refers to these as “shock periods.” Shock periods aren’t necessarily triggered by negative performance for markets, even though most assets do go down during shocks. From March 2000 through February 2003, the NASDAQ Index declined from more than 5,000 to less than 1,500. During this period, global markets generally functioned as effectively as they had the previous three years. Borrowers found lenders, sellers found buyers, and similar instruments behaved similarly while different instruments behaved differently. Cheaper assets drew interest from buyers (and more expensive assets drew sellers), creating a negative feedback loop to help correct market mispricings. This combination of normal credit, liquidity, and correlation patterns with stabilizing feedback processes defines for us normal market function.
By contrast, shock periods are defined by market failure: credit and liquidity are scarce, technical factors outweigh fundamental data, and the financial system displays positive feedback behavior (as where selling drives prices down, and falling prices generate more selling pressure).
The 1998 hedge fund crisis highlighted by the failure of Long Term Capital Management (among others) is a classic example.
Risk managers often focus their attention on normal periods because the data are better. Statistical tests show greater validity for observations derived from large data sets than from small data sets. Data sampled from normal periods are more predictive of out-of-sample outcomes than data derived from shock periods. And, perhaps most important on Wall Street, investors who focus their risk management efforts on normal markets typically make more money than people who focus on shock exposures. Until they don’t.
Nevertheless, we believe that risk management in normal periods is by a large margin the easiest, and least important, risk management task for investors. Much of this is the happy result of our investing in the hedge fund space. The rich returns to successful hedge fund managers have given rise to a spectacular diversity of investment strategies among which an investor can choose. By being careful to select managers who do different things, an investor can eat as much of diversification’s free lunch as its appetite allows. The second benefit of investing in hedge funds is the opportunity to find managers who hedge out exposure to major market risk factors. The chance to get paid well for delivering a skill-based return whether markets go up or down is attractive enough to encourage many skilled managers to forego the riskier model of depending on gross market movements to determine the bulk of their annual performance. Sadly, though, focusing investments on managers who seem market neutral in normal markets should give investors little real comfort that they have properly understood (much less managed) their shock risk exposure. Shocks are, by definition, periods when markets behave abnormally. Accordingly, a good understanding of shock risk dynamics requires us to turn to a less empirical, more theoretical, approach to risk mitigation.
“Will you walk into my parlor?” said the spider to the fly;
“‘Tis the prettiest little parlor that ever you may spy.
The way into my parlor is up a winding stair,
And I have many curious things to show when you are there.”
“Oh no, no,” said the little fly; “to ask me is in vain,
For who goes up your winding stair can ne’er come down again.”
– Mary Howitt, "The Spider and The Fly"
Shocks don’t happen unless investors are surprised. The winding stair of liquidity suddenly looks much narrower than it seemed going in. Investors generally need to be forced to make uneconomic decisions to create and maintain a shock scenario: they need to sell and buy financial instruments away from what their fair value would be during a normal market. Investors are forced to reduce risk at exactly the moment when they believe that risk offers the most attractive prospective returns. This may happen because lenders have issued margin calls, or because the ultimate owners of capital have requested its return from agents. It may also happen because market participants fear these factors will manifest themselves in the future. In any case the dominant factor driving these anomalous price movements is generally not a change in fundamental economic data. Instead, the technical factors of short-term supply and demand are the crucial drivers of market action. Risk management based on historical data is of less utility at such times.
Investors seeking to mitigate shock risk are left in a difficult place, then. Their primary risk control worry is the least susceptible to empirical analysis. Over the years, we’ve worked with faculty members of Columbia Business School to get a sense for whether there are more sophisticated empirical tools for understanding, forecasting, and managing shock exposures. The more time we spend on such data-driven approaches, the greater our confidence that resources expended in that domain will have limited returns. Instead, we believe investors should structure portfolios based on a broad understanding of how markets behave under stress, rather than by looking at historical market data. There are four key elements to this approach.
First, we think investors should drive capital to spaces with rich opportunity sets, and remove capital from spaces with poor opportunity sets. In 2002, there was a tremendous amount of uncertainty about the carnage in the distressed debt marketplace in the wake of unprecedented default behavior from U.S. corporates. In the wake of these losses, there was substantial uncertainty about the returns to be expected in corporate credit. From our perspective, this sort of hyperawareness of risk shifts latent shock exposures into the more manageable normal world. Nobody is surprised by credit losses in an environment when people talk of nothing else. Without the prospect of surprise, you don’t find shock risk.
Second, we think investors should focus on selecting managers who think about and manage shock risk in a very proactive way. People who suffered through previous shocks tend to be very happy giving up returns today to increase portfolio stability tomorrow. They will agree to pay higher fees for less leverage, but will have multiple prime brokers, term financing agreements, long notice provisions, and they will protect their reserves of unencumbered cash.
Third, we think investors should try to build portfolios that explicitly offer an inferior risk-adjusted return in normal periods in the belief that these portfolios will do better in the shock periods that come eventually. For example, investors can add managers from strategies without built-in shock exposures, even where these managers will degrade the portfolios’ risk-adjusted returns in normal periods. Quantitative macro funds often have Sharpe Ratios little better than 1 but can offer portfolios with as much liquidity and market risk on the long side as on the short side. While these managers are sub-optimal most months, the reduced structural shock exposure relative to a distressed fund (for example) is likely to benefit investors’ portfolios during the worst times.
Finally, investors should prepare their portfolio and management firm for post-crisis response. For long-term investors, it’s just as important how they come out of a shock as how they go into it. Historically, prospective returns for shock risk-exposed strategies go up substantially after shock periods. So investors should select managers who will be able to increase risk in very uncertain environments and maintain these risky positions as conditions return to normal. Effective post-shock allocations can mitigate the pain suffered during the shock period.
We think these four steps are sensible and intuitive for investors seeking to manage shock exposure. They move in the right direction, anyway. But investors can have very limited confidence whether they have moved far enough. Unfortunately, there’s no real way to know. Until we see a shock, we won’t have the data.
Which brings us back to our opening paragraphs. We made the argument that we believe the markets pay investors well to manage these risks, but we dodged the question of how we could make that assessment going forward. After all, we don’t think investors can know with any degree of precision when the next shock will happen, or how painful it will be. While the historical returns of arbitrage strategies through full market cycles have, in many cases, added very substantial value to portfolios, our confidence in using such data to forecast future returns is minimal.
In the end, our view is more philosophical than empirical. It’s hard for us to believe that we live in a world where the least efficient markets don’t offer, in aggregate, better investment opportunities than the most efficient markets. Of course, we know for certain that one of the costs of investing in less efficient markets is exposure to shock risk. At the same time, we believe that shock periods offer the best opportunities for skilled investors to set themselves apart. Indeed, that may be the best definition of what defines a skilled investor.
IMPORTANT INFORMATION ABOUT THIS ESSAY
This essay reflects the opinions and views of the authors and is not intended to describe any strategy, product, or services provided by Magnitude Capital, LLC (“Magnitude”). This essay is for informational purposes only, does not constitute investment advice or an offer to buy or sell securities, and should not be deemed to be a recommendation to make any investment. This essay, insofar as it discusses investment strategies, portfolio construction, and/or other investment-related themes, is general in nature and does not address any individual investor circumstances or risk-tolerances, which may vary significantly. The reader is reminded that an investment in any security is subject to a number of risks, including the risk of a total loss of capital, and that the discussion herein does not contain a list or description of relevant risks. The reader should make an independent investigation of the information described herein, including consulting the reader’s own tax, legal, accounting and other advisors about the matters discussed herein.
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